The Nasty Tax
Here we are, 2 years after getting rooked with a 5 dimensional tax system, and many people are still unaware of the Nasty Tax: 3.8% Net Investment Income Tax (NIIT). I think the IRS used Wal-Mart pricing strategy with 8’s when they derived the number so it the smell would go un-noticed. But since it’s tax time, let’s talk about what’s in the baggie.
The NIIT is a surtax of 3.8% that covers a broad category of investment income sources. Determining how the tax is applies involves a fairly simple two step calculation. But first, let’s cover what’s included.
What’s Included: interest, dividends, annuities, royalties, rents, income from a business that is a passive activity with respect to the taxpayer, and net capital gain on the sale of non-business assets, reduced by any deductions properly allocable to such income.
Does not include salaries, wages, bonuses, distributions from IRAs or qualified plans, or self-employment income.
Are You Affected?
3.8% surtax that applies to the lesser of: 1. Net investment income (NII) or 2. The excess of your modified adjusted gross income (MAGI) over $200,000 (Single) or $250,000 (Married filing jointly). Remember, your MAGI is the amount reported on the last line one page 1, Form 1040.
First, add up your income subject to the Surtax.
|Subject to Surtax||Exempt from Surtax|
Next, look at the Threshold Amount
• Single taxpayers – $200,000
• Married taxpayers – $250,000
• Estates/trusts – $12,150
Example: Tammy, a single taxpayer, has $225,000 of net investment income and no other source of income. The 3.8% surtax would apply to $25,000 of income. (the lesser of investment income of $225,000 or the excess of $225,000 MAGI over $200,000 “threshold amount”).
Example: David & Darla, married filing jointly, have $200,000 of salaries and $150,000 of net investment income for total MAGI of $350,000.
The 3.8% surtax would apply to $100,000 of income because the excess of $350,000 MAGI over $250,000 threshold amount is $100,000 and LESS than their NII of $150,000.
How to Reduce NIIT
1. Look at Your Dividends. There can be a meaningful difference in the tax rate on ordinary versus qualified dividends (43.4% versus 23.8% highest brackets).
- Review your 1099 statements.
- Lines 9a and 9b on your 1040:
Tax-inefficient mutual funds can generate short-term capital gains, which are classified as ordinary dividends. Consider a tax-managed implementation, or if dividends are not needed for cash flow again, consider asset location.
- Taxation of Traditional Dividends- Ordinary Income
- Taxation of “Qualified Dividends” – Capital Gains Rate of 15%
2. Taxable Interest: Interest Income is taxed at ordinary income rates. Consider ways to reduce taxable interest with municipal bonds versus taxable bonds.
Consider asset location; placing tax-inefficient asset classes in tax-deferred and taxfree accounts.
- Lines 8a and 8b on your 1040:
3. Capital Gains: Long-term Gains are Taxed at Lower Tax Rates
Reduce the capital gains by using these tools:
- Tax-lot accounting: A method of accounting for a securities portfolio that tracks the purchase, sale price and cost basis of each security. This allows the manager to “swap” a batch of stocks with long-term gains for a batch with smaller, short-term gains.
- Loss harvesting: Holding a stock at a loss to sell all or part of it to realize the loss and create an “asset” that may help offset some future gain.
- Gain-loss offset: Involves selling securities at a loss that have dropped in price at year-end to help offset gains from selling securities that have increased in price.
- Charitable donations through gifting low basis stock.Line 13 on your 1040: In most cases, the optimal amount that should be here is -$3,000. The law allows a taxpayer to take losses equal to gains and then an additional $3,000 against ordinary income. If a positive number is reported here, were tax loss harvesting opportunities missed?
- Master Limited Partnerships (MLP’s): Deduction pass-throughs, lower taxable income, and tax deferral on distributions.